The year to invest in infrastructure

Macquarie fund manager Justin Lannen explains the opportunities emerging in the infrastructure market in 2011.

Infrastructure assets such as roads, bridges, airports and water provide essential services that underpin economic competitiveness.

There are three broad trends that are likely to be significant for listed infrastructure in 2011. The first is the fiscal position of many governments, particularly those in developed countries. It has deteriorated sharply as a result of the financial support measures provided during the global financial crisis and the recession that ensued.

In times of heightened financial stress, governments in some countries have historically needed to privatise assets and increase the private sector’s involvement in financing the provision of major new infrastructure. We expect to see this trend in 2011, thereby creating further opportunities for listed infrastructure investors.

In addition, central banks around the world continue to adopt supportive monetary policy through the maintenance of historically low cash rates and, in some cases, quantitative easing in an attempt to promote economic growth. With global interest rates expected to remain low for some time, we expect equity markets to continue to focus on stocks with high and sustainable yields, which will benefit the infrastructure sector.

Finally, merger and acquisition activity is set to continue in the infrastructure sector driven by building corporate cash levels, relatively cheap debt, and listed infrastructure securities priced at a discount to comparable unlisted ­infrastructure assets. This commenced in 2010 with several transactions to acquire listed assets, where the ultimate transaction price was at a material premium to the share price.

It should be noted, however, that some of the listed infrastructure stocks which were once in government hands have a particular barrier to takeover, given the government’s holding in the public company.

Opportunities are emerging in the infrastructure market in 2011 in five main areas:

1. Expansion of electricity
There is a strong need in some countries to expand and upgrade the electricity transmission grid, to meet a number of government objectives, including: increasing the reliability of electricity supply; improving energy efficiency (to reduce power lost through the grid); the connection of new sources of renewable electricity to assist meeting carbon reduction targets.

Incentives for priority capital expenditure on electricity transmission are provided by some regulators. For example, in the US, the Federal Energy Regulatory Commission continues to encourage investment in the interstate power grid, by granting certain incentives consistent with its Energy Policy Act of 2005 incentive rate policy. The policy aims to encourage greater investment in the nation’s ageing transmission infrastructure, promote electric power reliability and lower costs for consumers by reducing transmission congestion.

2. Strong Chinese growth
China continues to record strong growth and is expected to continue to strongly outperform the developed world, even as the Chinese authorities seek to pull growth back a notch or two. Investors should be looking to China for growth with potential investments into Chinese transport infrastructure such as toll roads, airports and seaports, all of which benefit from strong positive economic growth.

3. Toll road valuations
Toll roads were harshly treated during the market downturn in 2008. The market feared that traffic volumes would decline sharply and that revenue and earnings would also fall. Even though this expectation was contrary to historical experience, toll roads, like many other stocks, were aggressively sold.

In reality, traffic volumes dipped only briefly before recovering and the earnings of most toll road companies were resilient. While toll road stocks have bounced strongly from their lows, there is still significant value in many stocks. As one example, this assessment was vindicated in the second half of 2010 when Intoll Group was taken over by a Canadian pension fund at a premium of over 40% to its previous share price.

4. Initial Public Offerings
Towards the end of 2010, there were several infrastructure IPOs in Australia, Mexico and Italy. They were indicative of the continued potential for the listed infrastructure sector to grow. As mentioned previously, financial pressure on governments is likely to prompt some further selldowns via IPO in 2011, which will provide opportunities for diligent infrastructure investors.

5. Inflation
A significant amount of fiscal and monetary stimulus has been injected into economies around the world in an effort to restart growth. While inflation in most countries remains relatively subdued, there is a risk that this stimulus will presage a re-emergence of inflation. There is already interest in the listed infrastructure sector from investors attracted to real assets with cashflows that are wholly or partly linked to inflation. It is expected that this interest will increase, particularly if the inflation risk continues.

Overall, investors can look forward to 2011 with confidence, especially with regards to infrastructure investing. There are many stocks that perform well at the operational level, providing investment opportunities and a number of companies that have organic growth opportunities to invest in new or expanded infrastructure assets to earn a regulated return in excess of their cost of capital. Overall, 2011 is the year of infrastructure.